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May 15, 2023

The Time of Private Credit in Emerging Markets is Upon Us

Since the 2008 financial crisis, private credit has surged to become an attractive asset class with $1.4 trillion in outstanding allocations as of the end of 2022 – up from $250 billion (bn) in 2010. Last year saw a 89% increase in private credit investments, marking the highest increase on record.

To date, much of this activity has been concentrated in developed markets, in particular the U.S. and U.K. Yet private debt’s appeal has also started to extend to emerging markets (EM) amid increasingly favorable long-term structural shifts and changing market dynamics. From 2009 to 2019, private credit fundraising in EM tripled, from about $2.4bn to more than $8bn per year.

This growth has, no doubt, unfolded from a low absolute and relative base. EM private credit also remains a very small asset class relative to private credit in developed markets, as well as EM private equity. In 2021, private credit fundraising in North America and Europe touched $180.1bn compared to $11.9bn across all EM. That same year, EM private equity reached $145.2bn, with Asia as the largest market.

Still, we believe EM private credit will continue to grow. Indeed, the EM private credit opportunity has arrived.

At least three factors contribute to the sector’s EM growth. First, the post-pandemic world has proven to be fertile ground for the private credit community, especially as private equity sponsors have been sitting on plenty of dry powder and looking for debt to fund acquisitions. EM domestic lenders, too, have largely retrenched their middle market lending activities amid increasing regulatory pressures.

In sub-Saharan Africa, where private credit remains scant despite growing investor interest, private credit and infrastructure investments rose by some 118% in 2021. Domestic credit to the region’s private sector as a percentage of its GDP had fallen below its 2002 levels the year prior. This mismatch between credit supply and demand across all EM has created a business funding gap of about $5.2 trillion per annum.

In Latin America and Asia, where bank capital still comprises a considerable portion of overall credit capital, borrowers’ demands for flexible funding solutions have similarly created opportunities for private credit to bridge this unmatched gap.

In Latin America, senior loans – mainly to infrastructure projects and SMEs – accounted for half of the private credit investments in 2022. As companies have continued to shift production facilities closer to home to avoid the supply chain constraints that caused delays during the pandemic, demand for borrowing has grown.

Latin American private credit investments  jumped six-fold between 2017–2022, albeit from a near-negligible base. In 2017 the sector had raised less than $1bn. It had raised $5.8 billion as of end-December 2022.

Second, private debt – ranging from direct lending to special situations – continues to offer investors high levels of assurances in times of volatility, especially in EM. In the rising interest rate environment, the floating rate yield of private debt accords investors some downside protection. EM private debt also offers several protections that have become less available in developed markets. Creditor rights’ regimes, collateral systems, enforcement, and insolvency law frameworks have all been improving, propelling the market.

Regulatory changes have also continued to support the maturation of EM private debt. In India – which between 2018–2023 attracted the largest private credit volume ($9.5 billion) of all Asian markets – the local regulator SEBI in January this year allowed alternative investment funds to participate in credit default swap transactions, advancing the option to hedge risk associated with the bond market.

India’s performing credit market – which is largely investment grade – is expected to reach $89bn by 2026. Indeed, as India’s economy develops and grows – with a projected GDP growth of about 6-7 percent per annum to  2026 – private credit is anticipated to grow with it.

Finally, as an asset class, EM private credit is diversified across strategies and geographies. Alongside other key fundamentals, such diversification offers an attractive ‘Goldilocks’ risk-return – not too risky, yet not too bland.

As of September 2020, the median net IRR for EM private credit funds was 10.5% compared to 8.7% for EM private equity funds. Over the past decade, EM credit funds have generated average gross returns of about 12-15%, outperforming traditional fixed income investments.

For EM – where access to finance is a challenge to economic development and growth – private credit has steadily shown to be a key missing piece of the capital structure puzzle. While it remains a nascent asset class relative to EM private equity, its expansion is promising. As borrowers now search for longer-term partnerships, too, EM private debt is well positioned to play the role of partner.

With its non-dilutive character and more flexible and bespoke solutions, private credit can, critically, help to meet underserved capital needs in key EM growth sectors such as infrastructure, agriculture, and energy. This merger of impact and risk-reward suggests the EM private credit opportunity has indeed arrived – and will only continue to grow.

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